Why AA matters more than stock selection for multi-generational wealth

Stock selection is an art and a science. Selecting the right company for investment requires a constant and an in-dept study of various factors that can affect the equity markets and the stock. Before getting in to company specific details it is important to understand factors like local and global macro and micro economic environment, industry level nuances like supply chain and demand dynamics that can affect the stock.

Factoring risks

The recent geopolitical issues like tariffs and wars too need to be factored in. Post all this, company-specific factors need to be evaluated and constantly monitored. Aspects like management quality, investor relations and fair practices, balance sheet health, ability of management to proactively adept to the ever-changing environment, moats around the products and services provided, growth and margins history and forecast, and last but not the least, the valuation of the stock vis-à-vis the growth expectations and other competitive companies. That apart, risk for a stock emerges from various other aspects like natural calamities, frauds, tax liabilities, whistle blowers, and key-man risks. We have seen many stocks fall 50-80% and never recover from there.

Picking the right stocks

Stock picking requires a stoic mind with a strong conviction that can understand and accept the volatility in stock markets. The person should also have the cognitive ability to avoid behavioral biases that can lead to holding on to a stock for too long or taking an exit too soon. Some member in the family may have these abilities, but the risk is too high to take for the family. It is also important to note that all members and future generations of a family may not have the experience, aptitude, time and willingness to run an all-stock wealth portfolio for decades. For multi-generational wealth, a strategy to invest on basis stock selection creates concentration risk that can lead to serious erosion of wealth.

Diversity is the key

Depending only on a single-asset stock portfolio for multi-generational wealth is not advisable as it exposes the family wealth to extreme volatility, especially in times of prolonged economic downturns and geopolitical issues. For Indians, the problem compounds as there are capital account convertibility limits that restricts investment in other geographies and thus one cannot invest meaningfully in global non-Indian stocks and thus diversify.

While equites form a bedrock for wealth creation, a multi-asset portfolio that diversifies across asset classes and geographies (via the LRS and OPI routes) will provide adequate protection to capital as returns and volatility would have little correlation. In the recent past we have seen how investments in Gold, Silver, direct bonds and InvITs have protected portfolios when equity markets have given negative returns.

Various studies have shown that allocating investments across various asset classes and across geographies defines the returns that a portfolio can give over a long horizon, rather than selecting individual securities to invest in. Balancing investments across listed equity, fixed income, private markets, infrastructure vehicles (InvITs), and real estate can help create a portfolio that compounds return with a much lower volatility and can out-pace inflation.

Beyond returns

In the longer term, it is not only the returns that matter, what also matters is the peace of mind in managing and curating a portfolio for the current and next generations. Stock selection versus asset allocation for a family’s multi-generational investment journey is like comparing a short-lived individualistic approach versus an institutionalized approach via asset allocation. It’s a decade versus a century game where the longer horizon requires a approach that has adequate guard-rails that ensure wealth preservation and growth with reasonable risk. Like classically said “To make money you need to take risk but to keep money and protect dynasty, you need to manage risk”. Asset allocation is all about managing risk and squarely triumphs over stock selection.

Authored by: Nimish Shah, Managing Director, Family Office and Portfolio Analytics at LGT Wealth India